How 401(k) match thresholds and default rates affect savings

“Automatically enrolling employees into a 401(k) plan at a 6% salary default rate, rather than at the more common 3% default, means a higher savings rate for more people,” said Dallas Salisbury, president and CEO of the nonprofit Employee Benefit Retirement Institute, at a May 9, 2013, EBRI-sponsored policy forum on how plan-design decisions affect adequate retirement savings, held in Washington, D.C. “It’s more effective than encouraging greater savings through communications and education.”

“Participants look at the default rate and say, ‘My employer is telling me 3% is a good place to be,’ ” said Dan Campell, leader of consultancy Aon Hewitt’s defined contribution practice.

“In the end a majority will be led to success or failure based on plan design,” concurred Stacy Schaus, executive vice president and leader of investment firm PIMCO’s defined contribution practice. “Let’s get the defaults right because that’s where people are most likely to stay.”

According to Schaus, critical plan aspects include:

• Getting workers into the plan.

• Escalating employees’ savings rate over time.

• Encouraging broad diversification to reduce portfolio risk, through strategies such as investing in target-date funds that shift to less volatile assets as the designated retirement date nears.

Campell said that Aon Hewitt’s research shows that 70% of large plans have adopted automatic enrollment. Of these, 52% also have automatic escalation, and most of these (64%) escalate in 1% annual increases, up to 10% of deferred pay.

There are outliers, however: 8% of plans with auto escalation will raise rates up to a target default of 15% of pay; another 8% use a target default of 25% of pay.

‘Paper, Rock, Scissors’

In addition to auto enrollment, there are several levers to increasing contribution rates, including “stretch matching,” said Lori Lucas, executive vice president and defined contribution leader at consultancy Callan Associates. A stretch match involves raising the match threshold from, say, 6% to 10% of deferred pay. To keep the employer’s contribution cost neutral, plan sponsors would reduce the match amount from 50% on the dollar to something less.

“For the most part, plan sponsors are saying that the optimal savings rate would be at least 10% of pay, including the plan sponsor and participant contributions. And yet that’s not how most plans are structured from a behavioral standpoint,” Lucas observed.

Studies have found that the typical match is 50% on the dollar, up to 6% of a participant’s deferred pay. As noted, the typical automatic enrollment default rate is only 3% of deferred pay. “That’s not going to get participants up to a 10% savings rate if that’s where they stay,” she said.

Lucas discussed findings by researchers led by James Choi at Harvard University that showed the following: Company A offered voluntary enrollment and no employer matching contribution. It then introduced a match with a threshold of up to 4% of deferred pay. Soon after, participant contribution rates tended to cluster at the new 4% match threshold.

“People were saving to the threshold, which tended to pull up those saving less than 4% but also pulled down some of those saving more than 4%,” Lucas said.

In another Harvard research finding, Company B offered a matching contribution in a range of 25% to 100% on the dollar (depending on the division in which an employee worked), up to a match threshold of 6% of deferred pay companywide. Regardless of the percent on the dollar matched, deferral rates peaked at the 6% match threshold, again showing a cluster effect.

Auto enrollment beats match threshold

The Harvard researchers next looked at auto enrollment plans with varying matching structures. When auto default was set at 3% of pay, most participants were clustered at the 3% rate even though there was a 4% match threshold.

“There is evidence that the match threshold, while powerful under voluntary enrollment, loses a lot of its power under auto enrollment,” Lucas said. “In the game of paper, rock, scissors, default contribution rates beat match thresholds in terms of influencing savings behavior. The default savings rate under automatic enrollment is a very powerful motivator.”

Getting creative

Plan sponsors can better design their plans to promote participation and savings rates while controlling employer costs, Lucas pointed out. For example, Company C has auto enrollment, and its plan is structured as follows:

• A 100% match on the first 1% of a participant’s deferral from pay.

• A 50% match on the next 5% of deferrals.

• A 4% nonelective employer contribution (creating a “floor” for all employees, including those unable to save enough for the full match).

• Auto enrollment at 6% of pay.

• Auto escalation increase of 1% annually, up to 10% of pay.

Plan design should take into consideration employee demographics and income, along with the amount the employer is willing to contribute as participation rises through auto enrollment and auto escalation.

“Plan sponsors can keep costs down and facilitate more robust savings in auto enrollment plans by getting creative” with the match and other design elements, Lucas advised. “You can jiggle these numbers around and do different things to get to a cost-neutral state without sacrificing the default level” and the higher participant savings rate it can drive.

Stephen Miller, CEBS, is an online editor/manager for SHRM.

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